Tax Reform and the Markets

Tax Reform and the Markets

I have the good fortune of being invited to speak on various television news programs on a fairly regular basis. This month the main topic of choice has been tax reform and given that the Senate is voting on their version this week, I thought I’d present some thoughts and data on the subject.

I am often asked during my TV appearances if I think that any tax reform bill needs to be able to pay for itself. The short answer is yes, but there’s more to it – I am Irish after all! At the beginning of 2008, total public debt which includes federal, state & local was about 75% of GDP. Today it is over 110% of GDP. The interest rate we, the American taxpayers, are paying on that debt is incredibly low today by historical standards, but that debt is like an adjustable rate mortgage. We have no plans to ever reduce the debt, let alone pay it off so when big chunks of it come due, we need to get a new loan at current rates. If rates go up, that debt will cost us more and more. The more money that we have to pay on that debt, the fewer resources are available to invest in ways that can grow the economy.

I will point out though that rather than focusing on having tax cuts pay for themselves, we could look at ways to cut spending? In 1950 federal spending was 20% of GDP and the world wasn’t coming to an end. At the beginning of 2000, federal spending had grown to 31% of GDP.  This year it will account for about 36% of GDP. This level of spending comes at a time when unemployment is at 15-year lows. What happens when the inevitable recession comes? This is supposed to be the good times when we cut spending back and save up for the tough times.

What happens if we get bupkis from all this talk of tax reform? The current market valuations are so lofty and sentiment so lopsided bullish that there is no doubt in my mind that some level of cuts are already priced in, which means a hit if we don’t get them. The Republicans would likely have a tough time in the 2018 elections, which means that D.C. is likely to be even more dysfunctional as the Republicans try to shore up areas of weakness while the Democrats look to capitalize on the Republicans’ inability to enact reforms touted on the campaign trail.

Why do I think the markets are vulnerable? For starters, equities are really pricey: The trailing P/E ratio is higher today than at the 2007, 1987, 1976 and 1958 market peaks. The only time it was higher was during the 1999 dotcom lunacy. There is seriously lopsided sentiment with roughly 6 bulls for every bear. That is almost as lopsided as the all-time record pre-1987 crash. Even the c-suite has acknowledged that prices are inflated as share buybacks are at a 5-year low Finally, the US equity markets are a lot more expensive than many others around the world. Without tax reform, U.S. stocks will look less attractive than other international options as U.S. companies will continue to pay higher tax rates than the proposed rates.

Dow on Track for Longest Losing Streak Since 2011 as Trump Trade Stalls

Dow on Track for Longest Losing Streak Since 2011 as Trump Trade Stalls

We are shocked, shocked and just shocked I tell you. President Trump has not been able to effortlessly end the gridlock in D.C. and push through his agenda. Hmmm, something so new and novel for a resident of the White House.


This morning the Wall Street Journal reported that,

Stocks around the world fell Monday, putting the Dow Jones Industrial Average on track for its longest losing streak since 2011 as doubts percolated about the Trump administration’s ability to push through on campaign promises.

You don’t say. Doubts? Why on earth? Apparently, others are starting to wonder just how easy this is all going to be for the new administration,

“There is some real concern about whether [President Donald Trump] is going to be able to get these policies through,” said Dianne Lob, managing director for equities at AB. “I think the theme for the year will be uncertainty.”

“Markets are questioning the high expectations built over the past few months,” said Jeremy Gatto, investment manager at Unigestion. “[Mr. Trump] did promise a phenomenal tax reform package, and the market would be disappointed if we got something smaller than expected or nothing at all.”

What is surprising, we must admit, is that President Trump spent all of 17 days trying to push the ACA repeal/replace through. Let that sink in for a moment.

Donald the “I am the best dealmaker” candidate, who pledged that the first thing he’d do would be to repeal and replace the “disaster” of Obamacare, spent all of 17 days before calling it quits. Whether you think the ACA is a disaster or divine, on face value that doesn’t exactly look like solid effort. In comparison, it took Reagan about five years to reduce the top marginal tax rate from 70 percent down to 28 percent, but then Reagan enjoyed a higher approval rating at the time, which gave him more firepower. What we’ve seen here is that enough Republicans, never mind the Democrats, are unafraid of Trump to thwart his efforts.

That’s not a good sign for the markets that have had quite the run-up based on the assumption that this time things are different and with Trump in the White House, sky-high valuations make sense and economic realities, such as an aging population, are no anchor.

Never fear, though! Those financial talking heads are spinning this as a positive because now, (thank God!) Trump can focus on tax reform, which will be the first attempt at major reform since 1986 no less! I’m sure that’s going to go much more smoothly given the consensus in Washington around spending, the national debt, and income inequality. Remember too that the Ryan plan for health care would have reduced the budget by $1 trillion, so any reform is already in the hole $1 trillion, but I’m sure this won’t be a problem – eye roll.

Then there is that resolution that’ll need to be passed in April to keep the government funded and then we get to experience yet another debt ceiling debate this summer. Get that popcorn ready, we are in for a show, which means more rocking and rolling in the markets as investors get their arms around just what are reasonable expectations for the new administration.

Up next for the Trump team, tax reform, deregulation, and infrastructure. Regardless of whether you love Trump and his plans or hate them, today the probability of success on any of those items is lower today than it was just a few weeks ago. Their successful implementation was expected to usher in accelerating growth, which would lead to inflation, but when we look at the yield on the 10-year Treasury today, we see it is still well within its multi-decade long-term downtrend. (Pulled from YCharts)


If the bond market was buying into this great acceleration story, would the 10-year yield really be at 2.4 percent? Mr. Bond market remains skeptical.

Keep in mind that over the past few months, the year-over-year data for commodity prices has been off of extremely low levels as the sector experienced quite the downturn this time last year, making small changes, on a percent basis look unusually large. If, as I suspect, we are not actually seeing a sustained acceleration in the economy, these increases should begin to moderate over the coming months. Stay tuned…

Since the beginning of March, all the major U.S. equity indices are down, from the small cap Russell 2000, down 4.2 percent to the S&P 500, down 2.2 percent to the Dow Jones Industrials down 2.5 percent. U.S. bank stocks have fallen around 8 percent from their recent highs, that’s a bit wobbly for what could be the first earnings season to toss cold water on those sky-high growth expectations under the new administration.

Bottom Line: The market’s “This time it’s different” fairy tale is fading. With earnings season right around the corner, we will be getting some hard data on just what is actually happening versus the optimism. We’ll keep you posted!

Source: Dow Poised for Longest Losing Streak Since 2011 – WSJ

Reaganomics v Trumponomics

Reaganomics v Trumponomics

The market has been giddy as all get out over the fiscal policies that it expects the Trump administration will push through in a relatively short period. We’ve discussed at length how the timeliness of legislation is likely to be less timely than the market is hoping for, so we’ll leave that alone for now. Instead, let’s just look at the potential impact of these moves, taking into account the impact of similar legislation in the past.

The popular refrain we keep hearing bandied about is a reference to the post-Carter economic boom of the 1980s under President Ronald Reagan. Team Tematica would love nothing more than to get back to that type of rip-roaring growth — not to be self-serving, but such an environment makes the job of an investment professional a heck of a lot less stressful when everything is going up!

Here’s the thing, there are more than a few material differences in the state of the nation and global economy that no mere mortal inhabitant of the White House could resolve in a matter of months or years. President Trump is indeed a mortal… granted an unusually orange one, but a mortal nonetheless. Sorry, that was too easy of a shot not to take, but let’s look at some of those differences…

First, when Reagan took office, the total debt to GDP of the United States was just over 30 percent. Can you imagine? The headlines back then were also all about getting debt spending under control that the nation needed to work towards a balanced budget. When President George W. Bush took office the debt to GDP ratio was 57 percent. Today debt to GDP ratio is around 105 percent, 75 percent higher than when Reagan began, and around the levels at which warnings bells were going off concerning Greece a few years ago.

Many studies, most famously the one by Carmen Reinhart and Kenneth Rogoff entitled This Time is Different: Eight Centuries of Financial Folly, have shown that as sovereign debt levels get above a threshold level, growth becomes increasingly hampered.

In other words, Reagan had a lot more wiggle room for fiscal stimulus.

We can see the impact of this debt burden in the fiscal spending multiplier. According to an analysis by Lacy Hunt, Ph.D. of Hoisington Management, from 1952 to 1999 $1.70 of government debt spending generated an additional $1 of GDP. From 2000 to 2015, each additional $3.30 of government debt spending generated an additional $1 of GDP. By 2015, it took $5 of government debt spending to generate $1 of GDP. Ah yes, the law of diminishing marginal returns we heard too much about in economics classes.

Speaking of fiscal stimulus, the markets are ecstatic over expected tax cuts both at the personal and corporate level. Back when Reagan took office, the top marginal income tax rate was 70 percent, which was cut during his two terms to 28 percent. Today the top marginal tax rate is 39.6 percent, giving Trump a lot less room for reductions.

The workforce also looked a lot different under Reagan than it does today, as is reflected in our Aging of the Population investing theme. During Reagan’s term the working age population growing much faster than it is today.



The participation rate was also rising significantly and was at a materially higher rate than today. Today the United States has both the oldest population and the weakest population growth in its history. In 2016 population growth was 0.7 percent, which is the lowest since the 1935-1936 period with the fertility rate for women aged 15-44 tied for the lowest on record in 2013. For a bunch that looks heavily at thematic tailwinds, that is a major demographic headwind to growth.


With a lot more room to drop the top marginal tax rate and a much faster-growing workforce, Reagan was able to get a lot more bang for his buck. Today the current household formation rate is a painful 0.7 percent versus the average from 1960 to today of 1.6 percent.

Back when Reagan took office, the savings rate was around 10 percent, whereas today it is about 5.4 percent. From 1900 to the present, the average savings rate has been much higher, at 8.5 percent, which means we are likely in the later stage of the expansion when pent-up demand has been exhausted with savings for many negative when we look at savings rate by income/wealth levels. With many living paycheck-to-paycheck, as we regularly discuss in our Cash Strapped Consumer theme, the economy is increasingly vulnerable to shocks. This low savings rate also has repercussions inside our Aging of the Population investing theme, especially since roughly half of all baby boomers have little to no retirement savings.

Disposable personal income per capital growth over the past ten years has been less than 50 percent of the norm since World War II. Higher income allowed for a higher savings rate that also generated higher returns which translated into greater spending capacity, as interest rates were much higher.

During Reagan’s term, the 10-year Treasury rate dropped from a peak of nearly 16 percent to a low of 7 percent – talk about stimulative! Today interest rates remain near record lows with the Fed in the midst of a rate hike cycle. On top of that, we are seeing the beginnings of tightening loan standards and declining demand for credit, which is part of our Economic Acceleration/Deceleration theme.

From the Federal Reserve’s January 2017 Senior Loan Officer Opinion Survey on Bank Lending Practices, the most recent data available:

Regarding loans to businesses, the January survey results indicated that over the fourth quarter of 2016, on balance, banks left their standards on commercial and industrial (C&I) loans basically unchanged while tightening standards on commercial real estate (CRE) loans. Furthermore, banks reported that demand for C&I loans from large and middle-market firms, alongside small firms, was little changed, on balance, while a moderate net fraction of banks reported that inquiries for C&I lines of credit had increased. Regarding the demand for CRE loans, a modest net fraction of banks reported weaker demand for construction and land development loans and loans secured by multifamily residential properties, while demand for loans secured by nonfarm nonresidential properties reportedly remained basically unchanged on net.


Regarding loans to households, banks reported that standards on all categories of residential real estate (RRE) mortgage loans were little changed on balance. Banks also reported that demand for most types of home-purchase loans weakened over the fourth quarter on net. In addition, banks indicated mixed changes in standards and demand for consumer loans over the fourth quarter on balance.


Most domestic banks that reportedly tightened either standards or terms on C&I loans over the past three months cited as an important reason a less favorable or more uncertain economic outlook. Significant fractions of such respondents also cited deterioration in their current or expected capital positions; worsening of industry-specific problems; reduced tolerance for risk; decreased liquidity in the secondary market for these loans; deterioration in their current or expected liquidity positions; and increased concerns about the effects of legislative changes, supervisory actions, or changes in accounting standards.


This is typical of the later stages of the business cycle and regardless of what the Trump administration does, is a headwind to growth. In addition to the survey, we can see that since peaking around January 2015, the loan growth has been declining significantly, again one of the headwinds of our Economic Acceleration/Deceleration theme.


We can also see rising rates reflected in LIBOR rates, to which many mortgages are tied, which helps explain the declining demand for mortgages.

Finally, for investors, there was a lot more room for stock prices to go up in the 1980s compared to today’s market.


When Reagan took office, the Shiller Cyclically Adjusted Price-Earnings ratio was under 9, dropping to less than seven as Paul Volker hiked interest rates dramatically to crush inflation. By the end of his term, it had risen to just over 17 then continued to increase during the 1990s, peaking in 1999 at over 43. Today this measure stands just shy of 30, nearly four times what it was shortly after Reagan took office.

To put it all together, Reagan benefited from a labor pool that was growing much more rapidly than today, a higher starting point for the marginal tax rate, the stimulative effects of falling interest rates and a higher starting savings rate. During Reagan’s term investors benefited from much lower starting stock valuations.

The bottom line is that while many of the policies suggested by the Trump administration would likely have a stimulative effect, they must be assessed within the context of today’s economic reality.

Mornings with Maria

Mornings with Maria

On Friday October 21st I was on set with Maria Bartiromo, Kat Timpf and Dagen McDowell with a variety of guests. Here are a few clips from those three hours on set… with only one bathroom break… starting at 6am… and a lot of coffee…know my pain.

We spoke with JMP Securities President Mark Lehmann on the stocks to watch in the tech sector and the election’s impact on the markets.

Screen Shot 2017-01-26 at 2.27.56 PM

We also spoke with Alan Dershowitz, author of ‘Electile Dysfunction,’ on the impact of WikiLeaks on Hillary Clinton’s campaign. While I’m not a fan of lawbreakers, and hackers certainly count amongst those, these days the electorate is reasonably mistrustful of those in power and these hackers are giving us confirmation that we are correct to mistrust …which is one of the reasons I am in favor of smaller government. The more power government has, the more opportunities there are for graft, and the bigger the temptation to give into such. I prefer smaller government out of respect for the frailties of human nature. I’m in good company here with James Madison who explained it best in Federalist Paper #51.

It was a long chat with Mr. Dershowitz…

As a proponent of the free markets, which also means free trade, I’m a fan of Donald Trump’s plans to reduce taxes, but not a fan of his threats to significantly reduce free trade and to use the power of the presidency to force private companies to bend to his will. As the second largest exporter in the world, our economy needs a healthy level of international trade. We spoke with political economist Andy Busch on Donald Trump’s and Hillary Clinton’s competing plans.

Finally we spoke with S&P Global Market Intelligence’s Rich Peterson concerning the outlook for M&A activity, particularly given the current political environment. As we discussed earnings results so far, I brought up my concerns that the improvement in earnings per share really doesn’t tell the whole story, as companies have been buying back their own shares at record levels. This means the denominator, shares outstanding, keeps falling which makes EPS look artificially stronger than it actually is. I call this the spanx-and-push-up-bra strategy, whereby things may look better from afar, but fundamentally they really haven’t improved.

Obama Claims Country Better Off Today?

Obama Claims Country Better Off Today?

Obama claims the country is better off?  Uh, what? Last week President Obama told a small group of wealthy donors that by almost every metric, the U.S. is significantly better off under his leadership than under Bush’s. Oh dear God this is just getting embarrassing! Can we please have a little reality check here?



The most basic metric for how well the country is doing is median household income – are families making more today than in years past?  Errrr, not so fast there Mr. President. As the chart below shows (the red line) we are still well below we were when you took office… and that is despite the massive amount of government spending and monetary policy stimulus! Or perhaps, this is in fact because of all that insanity? In fact, median household income, after taking inflation into account, is where it was back in 1989, twenty-six years ago!

2015-07 Median Household Income


One of the reason household income is so low is that despite the often touted “unemployment rate” the more important number, the percentage of people in the country actually working is down to levels not seen since the early 80s and well below the ratio during George W Bush’s Presidency.

2015-07 Employment Population Ratio

On top of that, 2.2 million Americans are in part-time jobs who want to work full time, still far above the level at the start of the recession and during George W’s entire Presidency.

2015-07 Part-time for economic reasons


So people are making less and fewer people are working… what about the debt burden on those who do have jobs?  When Obama took office, the total Federal Debt was 10.7 trillion. Today it is over 18 trillion and expected to be well over 19 trillion by the time he leaves office.  That’s more than an 80% increase in the debt burden shouldered by the American people in just 8 years, nearly doubling!

2015-07 US Total Public Debt

This has also been the weakest economic recovery in the nation’s history. For the first time ever, U.S. GDP has contracted twice since the recovery and on an annual basis remains well below historical norms. Normally after a recession, we experience a period of above average growth which helps repair the damage experienced during the recession.  Not only did we never get that above average growth, but the economy continues to stumble along at very weak levels.

Just exactly what is it that you are looking at Mr. President?  As the “most transparent Administration in history,” (snort, chuckle, eye roll) how about if you show us?


What Deleveraging?

What Deleveraging?

2014-11-19 Global DebtWhat deleveraging?

China, the nation that helped bull the global economy out of the last financial crisis, is slowing markedly. China is also facing a debt problem. From 2002 to 2008, China’s total debt/GDP ratio was fairly stable and remained below 150%, but is now about 250%. It is possible that China’s debt issues may be contained within the real estate sector, which is the most troublesome part of the Chinese economy. It remains to be seen whether that distress bleeds into the broader economy. For now, corporate credit conditions in China still remain stable.


For that matter, debt across the world in both developed and emerging economies has once again reached new highs, making for a highly leveraged global economy, which as we’ve seen before makes for heightened volatility. The chart at right illustrates the magnitude of the debt.


As we’ve mentioned before in these pages, corporations have been pushing everything they can to get earnings from cutting costs as much as possible to avoiding internal investments so much so that by now, according to the Commerce Department, the average age of fixed assets, such as plants and factories, is about 22 years-old, the oldest average going back to 1956. That doesn’t sound to us like a set of solid fundamentals for a high-flying market.

Real vs Financial Economy:  Thoughts from Monte Carlo

Real vs Financial Economy: Thoughts from Monte Carlo

Last week I had the great honor of being invited to speak at the XIIth Annual International CIFA Forum, (the Convention of Independent Financial Advisors which is in special consultative status with the United Nations) in Monte Carlo. Who knows how I got invited back after speaking there last year, but when someone asks me speak in front of such an impressive audience, I don’t question. The conference is truly first rate with phenomenal guests as well as speakers, excluding of course the statistical anomaly of yours truly. If you find yourself in Monaco, I recommend staying at either the Hotel Hermitage or l’Hôtel Métropole and you cannot miss dining at Joël Robuchon at Métropole. If you want to see more of the famed nuttiness that is Monte Carlo after dark, make your way to Buddha Bar and I guarantee you’ll come away with stories to entertain for hours.

I highly recommend driving into Monaco from the Italian side on the Autostrada dei Fiori, (A10) which essentially means the highway of flowers. The road is high on the side of sheer mountains, winding along the coast of the Mediterranean, with countless bridges followed by tunnels and as you wander through the beauty of the land where the Maritime Alps meet the sea. Greenhouses, full of brightly colored flowers, dot the mountainside with unexpected flashes of color amongst the lush shades of green. As you look south, the Mediterranean’s beauty changes throughout the day as her moods softly sway, ranging from bright aquamarine, to the more subtle tones of oxidized copper to a moody ashen navy. Looking back towards the mountains, you may even catch sight of snow covered peaks. Surely some of the heavens’ best work is to be found in Italy. The drive however, is not well suited for those who have a significant fear of heights as the picture at left illustrates!

At the conference I spoke about the real vs financial economy, which is a topic that I’ve alluded to often in these monthly pages. This month let’s go a bit deeper. When we think of the economy, it can be broken into two distinct aspects: the real and the financial.

The real economy is what we primarily think of when referring to the economy. It is essentially composed of four types of capital:

  • Natural capital provides the basis for all human activity. It consists of raw natural resources such as minerals, timber, water etc. From this platform, human capital combines with social capital to general built capital and intermediate goods.
  • Human capital refers to individual productive capacity
  • Social capital refers to the networks and connections between individuals that facilitate the production of, and exchange of, goods and services.
  • Built capital refers to the man-made materials and productive devices utilized by human capital to produce desired goods and services.

The financial economy is essentially the world of money, including the various prices for money, namely interest rates and exchange rates. The financial economy overlays and supports the real economy by facilitating transactions and setting market prices for the stock and flow of the four capitals in the real economy.

When the real economy is healthy, market prices reflect the value of the true contribution of the four capital stocks and the real and financial economy align. In this environment debt and equity markets, as a percent of GDP, are small and are principally designed to channel savings into investments.

When the two are misaligned, and the financial economy dominates, the capital market is far larger than GDP and channels savings not only into investments, but also continuously into expanding speculative bubbles. The danger of this arrangement is somewhat intuitive. When there is more money floating around than the underlying real economy calls for, that money is going to race about nervously, seeking ways to generate returns. Since it is not attached to anything real underneath, its flows can be quite volatile, with bubbles able to quickly form and dissipate even more rapidly.

That is not to say that bubbles don’t occur when the real economy dominates, but those bubbles tend to stay small and have little impact on the overall economy. In the real economy, bubbles tend to be contained by the availability of savings and credit, whereas in the financial economy (where capital markets are disproportionately large relative to the real economy), the effectively unlimited availability of credit leads to speculative bubbles, which cause enormous price distortions and excessive flow of capital from the real economy into the bubble. We saw this occur in housing boom that reached its pinnacle in 2007 and has as of yet only recovered, on a national basis, about 1/3 of the cumulative decline during the recession.

When bubbles form in the financial economy, the size of the “white elephant” investments can be so large that the economic benefits that arise from an investment boom are dwarfed by the damage from the inevitable bust. In the most recent housing boom and bust, excessive investments were made in the housing industry on the somewhat Ponzi-style belief that prices would simply continue to go up and up. (Hmmm, I believe we mentioned the dangers of chasing returns in our prior section!) That led to more and more people building skills in construction, mortgage generation and other housing sector-specific skills. At the end of it all there were too many people working in a sector with too much capacity built up, so all those people and the physical capital that goes along with them needed to get shifted around into other parts of the economy; an arguably painful process for those who have to endure it.

So just how big has the financial economy become? According to data from the World Bank, stock market capitalization to GDP for the US has risen remarkably in recent decades. In 1990, it was just under 57.6%.

In 1999 it peaked at 162%, dropping to 115% by 2003, only to once again rise up to a peak of 141% in 2007. After the crisis, it fell to 97% in 2009 and is now back up to about 115%, still about twice where it was in 1990.

If we look at total credit market debt as reported in the Federal Reserve Flow of Funds report, in Q1 1990, total debt to GDP was 120%. In April 2009 that number had more than doubled to 274% and is now about 245%.

Now that’s all very interesting, but how does it pertain to investing and why do you care?

When looking to invest capital, there are essentially two choices:

  • Allocate “entrepreneurially” to the real economy, meaning in the production of goods and services, or
  • Allocate “financially” in legal claims against such activities.

Think of “entrepreneurial” allocation as investing in your cousin’s new restaurant or in the construction of a new corporate office complex that your attorney suggested as opposed to the financial economy which is, for example, about buying shares of Apple, call options on General Electric or Ford bonds.

A study by Philipp Mudt, Niels Forster, Simone Alfarano and Mishael Milakovic looked at just this, by studying over 30,000 publicly traded firms in more than forty countries that represent 70% of the global population and about 90% of the world’s income, comparing both average rates of return and volatility of returns from 1997 to 2011. Unsurprisingly, average returns for investments in either the real economy or the financial economy were roughly equal, but volatility of financial returns was a magnitude higher than that of “real” returns.

When you think about this, it is somewhat intuitive. We know that in the real economy, profits face a negative feedback mechanism which helps establish a rather stable profit level; a fairly well understood process in classical notions of competition. A sector that is experiencing high profit levels will naturally attract more capital, which in turn attracts more labor, thus increases output, which eventually reduces prices as supply increases relative to demand and puts downward pressure on profits over time. As profits decline, capital has incentives to go elsewhere, and the reverse process occurs leading to higher prices and profits for firms that remain in the industry.

In the financial sector, rather than this negative feedback mechanism, we can see a temporary positive feedback mechanism and strong cross-correlations which can lead to an almost Ponzi scheme effect. Prices for a particular security or type of security rise. This rise attracts additional capital, and the momentum generated by speculators chasing the hot sector attracts more and more capital until finally you find yourself getting tips on the hottest sector or stocks from your cab driver and dry cleaner.

I call this a sort of market-directed Ponzi scheme simply because in the long run companies cannot afford to pay more to financial stakeholders than they earn from their real activities, thus financial returns are eventually tied to real returns… unless of course one seriously mucks with the financial economy, as is the case today. Under today’s conditions, the long run rule still holds, but “long” is much longer.

As all Ponzi schemes eventually fail when no new buyers can be found, the stock prices start to fall when new buyers cease to come in and existing owners struggle to find someone to take their shares when they need to cash out. We have all seen this accelerating decline in various forms. Here’s the latest example. A lot of air has already come out of the euphoria for social media stocks in 2014. Most of the leading stocks in the social media sector are down substantially for the year to date through April 28th, including Linked In (-32%), Twitter (-34%), Yelp (-19%), Groupon (-40%), Youku (-25%), SINA (-43%) and Yandex (-44%). Speculators who chased last year’s bubbly returns in social media shares have been stung by substantial losses in the first several months of 2014.

One of the most striking aspects of the panel in Monte Carlo was unanimous concern regarding the significant potential risks in the global economy today as a result of the size magnitude of the financial economy relative to the real, the actions of central bankers during and after the crisis and the lack of any meaningful reform post-crisis. Gretchen Morgenson of the New York Times noted that financial crises seem to have become much more impactful on the overall economy and more severe in recent decades. She expressed concern that we have the makings for a much more severe correction in the future as she believes that few if, any of the causes of the last crises have been accurately and adequately addressed.

Roger Nightingale had a more distressing outlook than Ms. Morgenson’s, stating that he believes the world is in for one whopper of a depression when central banks find they have no choice but to cut back on the liquidity they’ve been injecting into the economy since the start of the crisis. He believes the cut back to be inevitable as he attributes the high levels of fraud we’ve seen in the financial sector to be a direct result of the excess levels of liquidity. He claimed that a sharp pull-back will be necessary, else society as a whole will cease to have any faith in our institutions if the fraud is able to continue at its current levels.

Louise Bennetts stirred the crowd with her assessment that Dodd-Frank has done very little to address the problems of the financial crisis and has in fact made the situation far more volatile as much of the legislation gives regulators considerable discretion concerning how to deal with bank problems. Throughout history, discretion translates into inconsistent treatment and typically to considerable levels of graft. These combine to inject significant uncertainty into the markets, which as we’ve already seen, increases instability in a sector that has not yet recovered. I highly recommend her work, along with Arthur Long on the impact of proposed bank regulations on global growth.

The group also engaged in a stimulating debate concerning why the media continues to present such a simple “all is well and let’s be on our merry way” version of the economy. Explanations ranged from lack of true understanding of the deeper data, to political positioning and the possibility that with the media cycle reality of today, there is no real interest in discussing risks that are more than a year or so out into the future. Whatever the cause, we could all agree that it certainly provides us with plenty of work with which to earn our keep!

Bottom Line: The size of the financial economy relative to the real economy has grown substantially in recent decades, making comparisons to historical norms difficult at best and misleading at worst. Additionally, sovereign debt levels are at perilously high levels relative to GDP for many of the world’s largest economies at a time when interest rates are at exceptionally low levels, (debt is likely to become increasingly more expensive over time) and aging demographics make future growth more challenging. While the current recovery looks to be thankfully gaining ground, longer-term significant problems loom large on the horizon; a reality to keep in mind when assessing portfolio risks. On the bright side, the market has done some correcting of the bubbly valuations in the most euphoric sector of 2013, social media, as expectations for what these companies can achieve in the real economy have come down.

An Evening with Nassim Taleb

I have the great fortune of traveling extensively for work and was recently lucky enough to be able to spend an evening with Nassim Taleb, sponsored by RBS (Royal Bank of Scotland) in Milan, Italy. His discussion focused on his most recent book, Antifragile, which I highly recommend, but he’s probably most famous for his tome, The Black Swan, which has become a staple of economic discussions. His comments were so intriguing that I thought I’d share a few, with my commentary in italics:

  • Too many decision makers in the world today do not have sufficient skin in the game, which degrades the quality of their decision making. Without skin in the game, decision makers have incentives to hide risks, thus the wisdom of Hammurabi’s the Law of the Builder in which bridge engineers slept under the very bridges they were building: those with the ability to have the most thorough knowledge would take on the greatest risk.
    This is one of the many reasons we prefer fund managers to have a considerable portion of their own wealth invested in the funds they manage.
  • Organic systems that are most likely to survive and thrive need volatility. Removing it slowly kills them. Consider the great lengths that various public entities have gone to in order to reduce volatility in the economy. By the time the financial crisis occurred, almost every bank executive in office had never experienced a financial crisis first-hand, thus their ability to accurately identify emerging risks and manage them was correlated with their lifelong experience in the “Great Moderation”. The Federal Reserve had for years assured them that it would make sure that a crisis was avoided. The consequence of this tempering of previously normal levels of volatility speaks for itself, in our experience with a financial crisis that surpassed any previously experienced.
  • GDP generated by borrowing ignores the future impact of having to repay those funds. In 2006, total US Federal Debt reached $8 trillion. It is now over $16 trillion. The debt incurred in the 230 years from 1776 to 2006, has more than doubled in the past 7 years.
Interest Rates and National Debt

Interest Rates and National Debt

Interest-Rates-and-National-DebtThe Federal Reserve has been under considerable pressure to provide details for just how it will control all the excess liquidity that it has created through quantitative easing. The Fed’s balance sheet, which can roughly be thought of as a proxy for the potential money supply, is almost 2.4 times the size it was in 2007. Last month I discussed how excess bank reserves have skyrocketed to nearly $1.7 trillion after having historically averaged near zero since the inception of the Federal Reserve. The Fed has argued that it will be able to slowly raise interest rates and carefully reign in those excess funds to prevent rampant inflation. This is something that has never in history been accomplished, so there is no clear roadmap for how to do this successfully, but for argument’s sake, let’s assume that the Fed is indeed capable. The question then becomes, “How will rising interest rates affect the economy and investing?” One of the largest impacts of rising interest rates will be on the financials of the federal government. The chart above shows the U.S. National Debt from 1950 to 2012 (left hand axis) and the annual deficit/surplus (right hand axis). The current national debt is over $16 trillion. Over the past 5 years, the annual deficit has averaged $1.4 trillion. The national debt as a percent of GDP is almost double what it was in 2007. The annual deficit is 9 times the size it was in 2007. The recent sequester cuts sent D.C. into apoplectic fits with dire warnings of impending doom, however those “cuts”, according to the Congressional Budget Office, represented a decrease in the amount of spending increase that is less than the total increase, which means there will still be an increase in net spending after the sequester, (see Congressional Budget Office “Final Sequestration Report for Fiscal Year 2013” published March 2013). Given the emotional hoopla and doomsday rhetoric, it is reasonable to assume that the current level of deficit spending is unlikely to decrease significantly anytime soon.

The current 10 year Treasury interest rate is about 1.8%. It reached its lowest level in July 2012 at 1.53% and the highest rate was 15.32% in September 1981 when Paul Volker put the kibosh on inflation. The historical average rate has been about 4.6%. The current annual interest payment on the debt is just over $220 billion. If interest rates were to rise to only the historical average of 4.6%, that would be an increase of 2.8%, which would be an increase of nearly $110 billion, if we assume for simplicity that all the new issuance is a 10 year terms. (The reality is that some would be shorter term, some would be longer, and this is just meant to give an approximation to illustrate the magnitude of the impact.) That means interest expense on the debt would increase a whopping 50% in the next year. If the deficit spending continued at about the same rate for the next 6 years, annual debt interest payments would become the government’s costliest expense by 2020. For every year that we continue to deficit spend, increasing the national debt, the magnitude of the impact of rising interest rates increases.

That puts the Federal Reserve into quite a pickle if the economy does in fact gets some legs and inflation ignites. Don’t raise rates and face punishing inflation. Raise rates and D.C. is going to be put under even more pressure to reduce spending. No wonder Chairman Ben Bernanke has been giving subtle indications that he isn’t keen on yet another term as Chairman!

Federal Reserve and National Debt

It took the federal government around 200 years to accumulate a trillion dollars in debt. Within the following decade it tripled that number, then doubled it again in just twelve years, and doubled it again in another 8 years. Overall the national debt has increased sixteen-fold in just 30 years. Incidentally, this period coincides with the complete delinking of the U.S. currency to the gold standard.

So how are we managing all this debt? In 2013 the Federal Reserve will buy approximately 90% of the country’s issuance of Treasuries and mortgage bonds! That’s one way to explain how a nation facing such a growing mountain of debt, a slowing to stalling economy, and a paralyzed political process is able to maintain such incredibly low interest rates. Treasuries have long been used as the standard for the risk-free rate. With only 10%
of the issuance to float freely in the market, the Fed is able to generate considerable demand for this “risk-free” asset class, driving prices up, which means driving interest rates down.

The massive distortions from the various Quantitative Easing programs have damaged the market mechanisms for understanding the true price of risk, which gives markets an understanding of the appropriate cost of capital. A market that no longer can obtain this information has a big problem, because mispricing of risk leads to misallocation of capital.

The proverbial saying goes that markets love to climb a wall of worry. We’ve seen corporate earnings and revenue growth slow sharply through the past year, with corporate guidance for future performance continuing to be rather grim, yet equities have had quite a run. This is due to expanding P/E multiples as we discussed in last month’s newsletter. This expansion is 85% correlated to the Fed’s ongoing balance sheet expansion, as it is now adding about $85 billion of relatively secure fixed income securities to its $3 trillion portfolio on a monthly basis. Such an enormous level of buying in the markets, leaving only 10% of new issuance available for purchase, is forcing investors into other assets, pushing up prices.

How is this level of Fed activity going to end? David Rosenberg of Gluskin Sheff described the situation well by saying,

“I am concerned over the unintended consequences of these experimental policy measures that have no precedence, but perhaps these consequences lie too far ahead in time from a ‘tactical’ sense, but we should be aware of them. The last cycle was built on artificial prosperity propelled by financial creativity on Wall Street and this cycle is being built on an abnormal era of central bank market manipulation.” January 17th, 2013.

Bottom Line: When one looks over the past 12 years of active Federal Reserve monetary policy in which we experienced repeated bubbles followed by painful pops, why does anyone believe this time will be different? Particularly when this time we experienced monetary activism on an unprecedented scale: we are truly in uncharted waters.